Wednesday, April 05, 2006

Worried about Inflation?

If you really want to get fancy, you could invest in Treasury Inflation-Protected Securities (TIPS). The principal of TIPS, is adjusted according to the Consumer Price Index. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases.

Interest and Principal
TIPS pay interest every six months. The interest rate is a fixed rate determined at auction. Though the rate is fixed, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate.

The Treasury provides TIPS Inflation Index Ratios to allow you to easily calculate the change to principal resulting from changes in the Consumer Price Index. To determine your inflation-adjusted semi-annual interest payment, simply follow this three step process:
  1. Locate your TIPS on the TIPS Inflation Index Ratios page. Follow the link and locate the Index Ratio that corresponds to the interest payment date for your security.
  2. Multiply your original principal amount by the Index Ratio. This is your inflation-adjusted principal.
  3. Multiply your inflation-adjusted principal by half the stated coupon rate on your security (i.e., 2%). The resulting number is your semi-annual interest payment.

When TIPS mature, we pay either the adjusted principal or the original principal, whichever is greater.

Terms and Price
TIPS are issued in terms of 5, 10, and 20 years, and are offered in multiples of $1,000. The price and interest rate of a TIPS are determined at auction. The price may be greater than, less than, or equal to the TIPS' par amount. (See prices and interest rates in recent auctions.)

Bottom line: Are They Worth It?
One way to calculate the possible advantage is to take a look at the average maturity of a 10 Year Treasury (4.3 % for example) and subtract the average maturity of a 10 Year Treasury Inflation Protected Security (2.5% for example). Once you get this number, you will know what inflation must be for the next ten years in order to make the purchase worth it.
Submitted by Yogi R

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